Income Tax Effects of Foreclosure & Other Relief of Debt

Summary:  If you negotiate a workout with a lender (including a short sale) where you are relieved of some of your debt, you will be issued an IRS 1099-C. You will have taxable income on which you must pay income tax unless you are insolvent or in bankruptcy. This can be a very big bite which could take years to pay. Don’t make the mistake of getting a forgiveness of debt if you may have to take bankruptcy later. Because you cannot later discharge this tax debt in bankruptcy. You would have no tax debt if you had taken bankruptcy first.  Use IRA Form 982 to avoid the income tax.

Income Tax on Forgiveness of Debt

A big problem with the forgiveness of debt which you get in a workout such as a short sale or a deed in lieu of foreclosure is that the forgiveness of debt is taxable income in the year of the forgiveness.

You must pay tax just as if you had earned that amount of money. This means that now you have another debt to pay, except that the new tax debt cannot be discharged in a later bankruptcy until it is more than 3 years old and you have not made an agreement with the IRS to "toll" the running of the 3 years.

This also applies to other debt reduction agreements, even credit card debt forgiveness. The lender is required by law to issue an IRS 1099-C to you for the amount of debt which is forgiven.

You must pay income tax on this amount unless you either are insolvent at the time of the debt forgiveness or you obtain the debt forgiveness after you file bankruptcy.

However, to claim insolvency, you must also consider your exempt assets, such as retirement assets. Your exempt assets may prevent you from claiming insolvency.

The best solution for you is to discharge the debt in bankruptcy. Then you pay no income tax.

IRS Form 982

However, there are 2 other ways to avoid paying income tax on the forgiveness of debt.  Use Form 982 to show that you were insolvent at the time of the forgiveness.